European Financial Management 2020 Archive

January 2020, VOL 26:1 March 2020, VOL 26:2

European Financial Management, VOL 26:1, January 2020

Limits‐to‐arbitrage, investment frictions, and the investment effect: New evidence

F. Y. Eric C. Lam, Ya Li, Wikrom Prombutr, K. C. John Wei

This study comprehensively reexamines the debate over behavioral and rational explanations for the investment effect in an updated sample. We closely follow the previous literature and provide several differences. Our tests include five prominent measures of corporate investment and corporate profitability in q‐theory and recent investment‐based asset pricing models. Both classical and Bayesian inferences show that limits‐to‐arbitrage tend to be supported by more evidence than investment frictions for all investment measures. When idiosyncratic volatility and cash flow volatility are used in measuring investment frictions, the inference is more favorable for the rational explanation.

Keywords: Limits-to-arbitrage; Investment frictions; q-theory; Investment, Stock returns

JEL Classification: G14, G31, G32, M41, M42

Director networks, turnover, and appointments

Luc Renneboog, Yang Zhao

This paper analyzes the labor market (turnover and appointments) of executive and non-executive directors by means of social network methodology. We find that directors with strong networks are able to obtain labor market information that enables them to leave their firm more easily for better opportunities. Networks also mitigate information asymmetry problems of external director appointments. Furthermore, the strong impact of indirect connections is in line with the ‘strength of the weak ties’ theory. The fact that direct connections are less important signifies that the connections to people that are close and local are likely to convey redundant information, whereas connections to distant individuals are more efficient in terms of information acquisition and labor market performance improvement.

Keywords: Corporate Governance; Director Networks; Director Turnover; Director

JEL Classification: G34, J4, L14

Corporate social responsibility: An umbrella or a puddle on a rainy day? Evidence surrounding corporate financial misconduct

John Bae, Wonik Choi, Jongha Lim

We examine the way a fraudulent firm's pre‐ and post‐misconduct corporate social responsibility engagement is associated with its stock performance to investigate the reputational role of corporate social responsibility (CSR). In the short term, firms with good CSR performance suffer smaller market penalties upon the revelation of financial wrongdoing, supporting the buffer effect, as opposed to the backfire effect, of a good social image. We also find that the misbehaving firms’ post‐misconduct CSR efforts are negatively associated with delisting probabilities, and positively with stock returns. These findings support the argument that increasing post‐crisis CSR engagement can be an effective remedy for a damaged reputation

Keywords: TBA

JEL Classification: TBA

NAV inflation and impact on performance in China

Mark Shackleton, Jiali Yan, Yaqiong Yao

Our study is among the first to examine the net asset value (NAV) inflation practices of fund managers in China, finding that equity funds bolster their portfolios at quarter‐end and especially year‐end. In support of the NAV inflation hypothesis in China, we further document the following: (1) NAV inflation is more profound for the worst‐performing fund managers; and (2) the stocks in which fund managers hold larger stakes exhibit a more marked pattern of price inflation around quarter‐ and year‐ends than do other stocks. We also find that closed‐end funds in China engage in NAV inflation at quarter‐ and year‐ends.


JEL Classification: TBA

Bank liquidity, macroeconomic risk, and bank risk: Evidence from the Financial Services Modernization Act

I‐Ju Chen, Yu‐Yi Lee, Yong‐Chin Liu

We investigate the empirical relationship between macroeconomic risk, bank liquidity, and bank risk surrounding the 1999 Financial Services Modernization Act. We propose that bank risk and liquidity are positively related as macroeconomic risk increases, and that this effect is particularly strong after the Gramm–Leach–Bliley Act (GLBA). We test our hypotheses by collecting data from 1994 to 2006 for banks in the United States. The results show that banks flush with liquid assets in a high macroeconomic risk environment conducted more lending activities following the enactment of the GLBA, leading to higher bank risk. Our study complements the understanding of bank liquidity management.

Keywords: TBA

JEL Classification: TBA

Manager skill and portfolio size with respect to a benchmark

Andrei Bolshakov, Ludwig B. Chincarini

Investment managers often manage a portfolio with respect to a benchmark. Typ- ically, they use a mean-variance optimization framework to maximize the information ratio of their portfolio. We develop an unconventional approach to this question. Given a set of assumptions, we ask what optimal percentage of the benchmark stocks should the portfolio manager select. This optimal portfolio depends on Fisher’s and Walle- nius’s noncentral hypergeometric distribution. We find that the optimal selectivity of a benchmark universe varies from 50% to 80%. These results are provocative, given that many enhanced index portfolio managers select a low percentage of the benchmark universe.

Keywords: Enhanced indexing, information ratio, portfolio management, active man- agement.

JEL Classification: G0, G13

Does trade credit really help relieving financial constraints?

Stefania Cosci, Roberto Guida, Valentina Meliciani

The European Union introduced a directive aimed at reducing trade credit due to its supposedly negative effect on the European economy. This contrasts with the redistribution view arguing that trade credit could facilitate the financing of credit-constrained firms by more liquid suppliers. But does trade credit mainly flow from relatively unconstrained suppliers to more financially constrained buyers? To answer this question, we look at the characteristics of net borrowers with respect to net lenders and then estimate the substitutability between trade and bank debt separately for the two groups of firms. Overall, the results show that, in Italy, efficient redistribution does not tend to prevail in the trade credit market

Keywords: Trade credit; redistribution view; financial constraints; substitutability.

JEL Classification: G32; G21; D82

Second and higher moments of fundamentals: A literature review

Yuecheng Jia, Ivilina Popova, Betty Simkins, Qin Emma Wang

This literature review outlines the recent progress in fundamental second and higher moments research. We survey the moments’ existence, formation, and financial market andmacroeconomic implications. Research shows that time-varying volatility and non-Gaussian shocks exist throughout all measures of fundamentals at both the micro and macro levels.Additionally, the granular network among firms helps explain the origin of fundamental second and higher moments. Empirical evidence shows that the moments have strong predictive power on asset prices and macroeconomic variables. We also highlight several areas wheremore research is needed to better understand the moments.

Keywords:Fundamental second moments, Fundamental higher moments, time-varying volatility, non-Gaussian shocks, granular network

JEL Classification: G12

Uncovering Predictability in the Evolution of the WTI Oil Futures Curve

Fearghal Kearney, Han Lin Shang

Accurately forecasting the price of oil, the world’s most actively traded commodity, is of great importance to both academics and practitioners. We contribute by proposing a functional time series based method to model and forecast oil futures. Our approach boasts a number of theoretical and practical advantages including effectively exploiting underlying process dynamics missed by classical discrete approaches. We evaluate the finite-sample performance against established benchmarks using a model confidence set test. A realistic out-of-sample exercise provides strong support for the adoption of our approach with it residing in the superior set of models in all considered instances.

Keywords: Crude oil, Forecasting, Functional time series, Futures contracts, Futures markets

JEL Classification: G10, G15, C53

European Financial Management, VOL 25:2, March 2019

News sentiment and sovereign credit risk

Lara Cathcart, Nina M. Gotthelf, Matthias Uhl, Yining Shi

We explore the impact of media content on sovereign credit risk. Our measure of media tone is extracted from the Thomson Reuters News Analytics database. As a proxy for sovereign credit risk we consider credit default swap (CDS) spreads, which are decomposed into their risk premium and default risk components. We find that media tone explains and predicts CDS returns and is a mixture of noise and information. Its effect on risk premium induces a temporary change in investors’ appetite for credit risk exposure, whereas its impact on the default component leads to reassessments of the fundamentals of sovereign economies.

Keywords: CDS, sovereign risk, credit risk premium, media tone

JEL Classification: G12; G15.

Do security breaches matter? The shareholder puzzle

Allen Michel, Jacob Oded, Israel Shaked

This article analyzes the effect of computer breaches on publicly traded equities from 2005 to 2017. An event study is performed and breaches analyzed conditioned on whether the breach announcement has been made in the mainstream media or through other channels. We find that in the period prior to the announcement date in the media, the mean abnormal return is negative, reflecting a likely leakage of information. In the period following the announcement date, the mean abnormal return is positive, often more than offsetting the previous declines. The findings have important implications for analysts, portfolio managers, institutional investors, and regulators.


JEL Classification:

Downside beta and the cross section of equity returns: A decade later

Yigit Atilgan, K. Ozgur Demirtas, A. Doruk Gunaydin

This study reexamines the relation between downside beta and equity returns in the U.S. First, we replicate Ang, Chen and Xing (2006) who find a positive relation between downside beta and future equity returns for equal-weighted portfolios of NYSE stocks. We show that this relation doesn’t hold after using value-weighted returns or controlling for various return determinants. We also extend the original sample, add AMEX/NASDAQ stocks or utilize alternative downside beta measures and still find no downside risk premium. We focus on factor analysis results, persistence of downside beta and various subsamples to understand the economic reasons behind the findings.

Keywords:downside beta, downside risk, tail risk, equity returns, asset pricing

JEL Classification: G10, G11, G12

Motivated monitoring by institutional investors and firm investment efficiency

Charles Ward, Chao Yin, Yeqin Zeng

We find that motivated monitoring by institutional investors mitigates firm in- vestment inefficiency, estimated by Richardson’s (2006) approach. This relation is robust when using the annual reconstitution of the Russell indexes as exogenous shocks to institutional ownership during the period 1995–2015 and after classifying institutional ownership by institution type. We also show that closer monitoring mitigates the problem of both over-investing free cash flows and under-investment due to managers’ career concerns. Finally, we document that the effectiveness of the monitoring by institutional investors appears to increase monotonically with respect to the firm’s relative importance in their portfolios.

Keywords:Institutional investors; Investment efficiency; Monitoring attention; Agency problem; Index switch

JEL Classification: G23; G30; G31; M4

Cash holdings in family firms: CEO identity and implications for firm value

Lorenzo Caprio, Alfonso Del Giudice, Andrea Signori

We investigate the cash holdings policy of family firms and examine potential value implications. Family firms hold more cash than other firms, with an average difference of 2.3% of total assets. This result is driven by firms managed by heir CEOs. While the cash holdings policy of first-generation family firms is more sensitive to firm risk, consistent with founders’ increased risk aversion, that of later-generation firms is more sensitive to information asymmetry and agency conflicts. Heir CEOs’ cash policies destroy value, as the marginal value of an additional euro suffers from a 38.3-cent discount, on average, relative to non-family firms.

Keywords:cash holdings, family firms, value of cash, family generation

JEL Classification: G30; G32; G35

Board diversity reforms: Do they matter for EU bank performance?

Francesca Arnaboldi, Barbara Casu, Elena Kalotychou, Anna Sarkisyan

We examine the impact of governance reforms related to board diversity on the performance of European Union banks. Using a difference‐in‐difference approach, we document that reforms increase bank stock returns and their volatility within the first 3 years after their enactment. The type of reform matters, with quotas increasing return volatility. The effectiveness of reforms depends on a country’sinstitutionalenvironment.Theimpactofreforms on return volatility is found to be beneficial in countries moreopentodiversity, withcommonlaw system and with greater economic freedom. Finally, reforms play a bigger role in banks that have ex ante less heterogeneous boards.

Keywords:bank performance, board diversity reforms, corporate governance codes

JEL Classification: G21; G30

When fund management skill is more valuable?

Feng Dong, John A. Doukas

Does fund management skill allow managers to identify mispriced securities more accurately and thereby make better portfolio choices resulting in superior fund performance when noise trading – a natural setting to detect skill – is more prevalent? We find skilled fund managers with superior past performance to generate persistent excess risk‐adjusted returns and experience significant capital inflows, especially in high sentiment times, high stock dispersion, and economic expansion states when price signals are noisier. This pattern persists after we control for lucky bias, using the ‘false discovery rate’ approach, which permits disentangling manager ‘skill’ from ‘luck.’


JEL Classification:

Intra‐industry bankruptcy contagion: Evidence from the pricing of industry recovery rates

Yuanchen Chang, Yi‐Ting Hsieh, Wenchien Liu, Peter Miu

How does bankruptcy contagion propagate among industry peers? We study the debt recovery channel of industry contagion by examining whether the cost of a company’s debt is affected by the observed recovery rates of its bankrupt industry peers. Our results show that lower industry recovery rates are associated with higher loan spreads, but only when the contracts were originated during industry bankruptcy waves. Consistent with the debt recovery channel of industry contagion, we find that the negative effects of industry recovery rates are significantly stronger under situations where the effect is expected to be more salient..

Keywords: Industry contagion, Recovery rate, Loan pricing, Debt recovery channel

JEL Classification: G30, G33.